1. Technical Field
The present invention relates to the field of commodity futures trading technology. In one aspect, the present invention relates to a method and system for promoting liquidity in futures markets.
2. Description of Related Art
In response to increased global competition between financial markets, Congress recently changed the U.S. regulatory environment to allow US-based financial markets to list new derivative products. In particular, the passage of the Commodities Futures Modernization Act in December 2000 lifted a ban on trading futures on individual equity securities that had been in place since 1982. Single stock futures (“SSFs”) are the first hybrid product listed in the U.S. that melds attributes of securities and futures. Although these products trade abroad on several foreign exchanges, as of today, no U.S.-based exchange or trading facility lists or trades SSFs.
A single stock futures contract (SSF) is an agreement to buy or sell shares of individual equity securities some time in the future at an agreed upon price. For example, someone who buys a March 2003 Intel futures contract has agreed to take delivery of 100 shares of Intel stock at a specified price in March 2003. Similarly, someone who sells a March 2003 Intel futures contract agrees to deliver 100 shares of Intel stock at a specified price in March 2003.
SSFs offer investors several important attributes. The three most commonly-cited are: (1) enhanced risk management; (2) reduced trading costs; and (3) short selling. First, investors may use SSFs to reduce risk in a portfolio in an efficient and cost-effective manner. For example, an investor, desiring to reduce its exposure to a certain equity security, may sell a futures contract on a single stock, thereby removing the equity security from an index fund that they hold. Similarily, an investor may want to increase its exposure to a certain sector security by purchasing a futures contract. For example, a mutual fund may want to temporarily increase its exposure to price increases of biotech companies by purchasing futures contracts on the Nasdaq Biotech Index, an exchange traded fund.
A second important attribute of SSFs is that they offer a leverage advantage when compared to shares of common stock. Leverage can be described as the amount of capital required to trade as compared to the value of the asset traded. When a small amount of capital is necessary to trade, the trade is described as “leveraged.” If a person were to trade common stock, the person must pay at least 50 percent of the stock's purchase price (or post at least $25,000 at a firm offering daytrading margins, in which case 25 percent must be paid), with interest charged on the remaining percentage. In this case, a financing charge arises because funds are being loaned to the purchaser to buy the stock. In contrast, if a person were to purchase an SSF, the person is required to post only 20 percent of the purchase price. Because SSFs do not require payment for the actual stock unless the contract is held to maturity, there is no interest charged on the remaining percentage. In other words, the money posted in an SSF transaction is similar to a performance bond.
A third attribute of SSFs is the ability of a trader to more easily engage in transaction in which to profit from a decrease in the price of the equity security. Currently, traders can profit from a price decrease of an equity security by engaging in a “short sale.” A short sale is the sale of stock not owned by the seller. Short sellers sell borrowed stock with the hope of purchasing the borrowed stock at a lower price sometime in the future. Often times, borrowed stock cannot be found, and therefore, a short sale cannot occur. Additionally, a trader must comply with the “up tick rule” before he can engage in a short sale. The up tick rule requires that a short sale may only occur on an up tick, i.e., the last sale was higher than the one previous to it. This rule makes it very difficult to engage in a short sale in a falling market. In contrast, SSFs are not subject to these restrictions—there is no stock to borrow and a person may be on the short side of a transaction at any time.
Unlike equity securities, SSFs are not fungible products. Fungibility refers to the ability to trade the same product across markets. For example, a person can purchase a share of IBM on the New York Stock Exchange and sell it on the The Nasdaq Stock Market. A share of IBM is said to be fungible. In contrast, many futures products, including SSFs, are not fungible. In other words, a trader cannot purchase an IBM futures contract on one exchange and sell (i.e., offset) it on another exchange. This is true even if the terms of the contract (e.g., size and delivery month) are the same at the two exchanges. For SSF contracts to be fungible, two or more exchanges must agree that all of the terms and conditions of a futures contract are the same, and must agree that the contracts are fungible. In addition, clearinghouses that will clear SSFs will have to create procedures that offset or effect delivery of a futures contract on an exchange that is different from the exchange in which the contract was intiated.
Historically, the futures markets have not competed against each other in fungible contracts. Once a market creates a contract, and captures initial liquidity in the contract, it is virtually impossible for another market to establish a competing pool of liquidity. As a consequence, rarely has price competition arisen across markets for substantially similar products. Because customers either will demand fungibility or the regulators will require it, SSFs may be one of the first futures products to be multiply listed and fungible across several futures and equity exchanges.
To promote liquidity, futures exchanges traditionally award franchises to specialists who undertake certain obligations for specified futures contracts. These obligations generally include agreeing to continuously provide both sell and buy orders for the specified futures contracts. In return, specialists receive incentives designed to compensate them for the risk of continuously providing liquidity. However, with respect to other liquidity providers, there are no incentives to bring liquidity to the market. This is more pronounced in the futures markets where there has not been competing pools of liquidity, and no need to reward liquidity provider who do not have a franchise.
In view of the foregoing, there is a demonstrated need for an automated futures trading exchange having enhanced liquidity by fairly rewarding all liquidity providers, as well as methods and apparatus for implementing same. Further limitations and disadvantages of conventional systems will become apparent to one of skill in the art after reviewing the remainder of the present application with reference to the drawings and detailed description which follow.